Unit V – Macro Economic and Business Decisions

Macro-Economic and Business Decisions: National Income and Business Policies

– Business Cycle and Business Policies – Inflation and Deflation – Monetary and
Fiscal Policies – Balance of Payments and Business Decisions

National Income: ―As a collection of goods and services produced to a common

bases by being measured in terms of money‖

According to Pigou "National income is that part of objective income of the

community, including of course income derived from abroad which can be
measured in money‖

According to Fisher ‗The national income consists solely of services as received

by ultimate consumers whether from their material or from their human
environment'.

Formula for National Income: Real National Income / Size of Population

Approaches of National Income

1. Production Approach: This approach calculates national income by

adding up the value of all goods and services produced within the
country's borders during a specific time period. It focuses on the value-
added at each stage of production, summing up all the value created
across various industries.
2. Expenditure approach: This approach measures national income by
summing up all the expenditures made on final goods and services within
the economy over a specified time period. It includes consumption
expenditures by households, investment expenditures by businesses,
government spending on goods and services, and net exports (exports
minus imports)
3. Income approach: This approach calculates national income by adding
up all the incomes earned by individuals and businesses within the
country during a specific time period. It includes wages and salaries,
rents, interest, and profits earned by households and businesses.

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Importance of National Income
1. Setting Economic Policy: National Income indicates the status of the
economy and can give a clear picture of the country‘s economic growth. National
Income statistics can help economists in formulating economic policies for
economic development.

2. Inflation and Deflationary Gaps: For timely anti-inflationary and

deflationary policies, we need aggregate data of national income. If expenditure
increases from the total output, it shows inflammatory gaps and vice versa.

3. Budget Preparation: The budget of the country is highly dependent on the

net national income and its concepts. The Government formulates the yearly
budget with the help of national income statistics in order to avoid any cynical
policies.

4. Standard of Living: National income data assists the government in

comparing the standard of living amongst countries and people living in the
same country at different times.

Factors determining National Income

1. Quality and quantity of factors of production: The availability and

efficiency of factors of production such as land, labor, capital, and
entrepreneurship are crucial determinants of national income. A country with
abundant and well-utilized resources tends to have higher production levels and,
consequently, a higher national income.

2. The state of technological know how? : Technological advancements play

a significant role in determining national income. Countries that invest in
research and development, adopt new technologies, and have a skilled
workforce capable of utilizing these technologies tend to experience higher
productivity levels and economic growth, leading to increased national income.

3. Political stability: Political stability creates an environment conducive to

economic growth and investment. A stable political environment reduces
uncertainty and risk, encouraging both domestic and foreign investment, which

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in turn stimulates economic activity and contributes to higher national income.
Conversely, political instability can lead to capital flight, decreased investment,
and economic downturns, negatively impacting national income.

Difficulties in Measuring National Income

1. Types of Goods and Services: The kinds of goods and services which
should be included in national income pose a problem. Goods and services
having money value are included in the national income but there are goods and
services which may have no corresponding flow of money payments. The
difficulty is whether these services should be included in national income and
how to measure their money value.

2. Problems of Double Counting: Another difficulty is of double counting

usually associated with the inventory method. Double counting implies the
possibility of a commodity like raw material or labour being included in national
income more than once, e.g., a farmer sells maize worth rupees two hundred to
a mill-owner, the mill owner further sells the maize flour to a wholesale dealer,
who further sells it to consumer; if we calculate it at every stage, its money
value will increase to eight hundred rupees but actually the increase in national
income has been to the extent of two hundred rupees only. The best way to
avoid this difficulty is to calculate only the value of all goods and services that
enter into final consumption. The problem of differentiating intermediate and
final products is very complex and acute in the computation of national income.

(3) Transfer Payments: Transfer payments are associated with the income
method of national income calculation. A person receives income of say Rs.
1,000 per year; part of it may have been received as interest payments on
government loans. This part is in the nature of transfer payments and may be
taken either as the income of the individual or of the government. If it figures
under both the categories, aggregate national income will be unduly inflated.

(4) Illegal Activities: All unlawful and illegal activities, whether economic or
not, are omitted from national income accounting. Income earned through illegal
activities like smuggling, blackmarketing, gambling, betting, adulteration,
bribery etc. are excluded on the ground that these activities are illegal and,

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therefore, cannot be included in the national income accounts. However, it is
very difficult to estimate such activities because their definitions or notions may
change from generation to generation or from society to society. In a free
market economy—who is going to say or decide— what is a socially desirable or
lawful activity? Thus, it is the larger issue of what constitute a lawful or socially
desirable activity that demands closer examination.

(5) Second-hand Sales: The most obvious item for exclusion from the national
income and product accounts is second-hand sales. In such sales the individual
or the economic units merely exchange ownership of an already existing good,
when no income is created in the process from current production. Even if a
profit is made, there is no income generated in the accounting sense, for the
gain is offset by the recording of the good at the transaction price by the buyer.

National Income Accounts

1. Gross National Product: GNP is the total market value of all final goods and
services produced by the residents of a country in a specific time period (usually
a year), regardless of where they are located. It includes both domestic
production and the income earned by residents from abroad minus the income
earned by non-residents within the country.

2. Net National Product: NNP is the total market value of all final goods and
services produced by the residents of a country in a specific time period, minus
depreciation (wear and tear on capital goods) and indirect taxes. It represents
the net output after accounting for the capital used up in the production process.

3. National Income: National income is the total income earned by individuals

and businesses within a country's borders in a specific time period. It includes
wages, salaries, rents, interest, and profits earned by households and
businesses, but excludes indirect taxes and depreciation.

4. Personnel Income: Personal income is the total income received by

individuals from all sources before personal taxes are deducted. It includes

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wages, salaries, rental income, dividends, interest income, and transfer
payments such as social security and welfare benefits.

5. Disposal Personnel Income: Disposable personal income is the amount of

income that households have available for spending and saving after personal
taxes have been deducted. It represents personal income minus personal taxes.

Business Cycle:
―Business Cycles are fluctuations in the economic activities of organized
communities‖

Phases of Business Cycle:

 Boom: This phase is characterized by a period of increasing
economic activity, rising production, employment, and income
levels. Consumer and business confidence tends to be high, leading
to increased spending and investment. Economic indicators such as
GDP growth, employment levels, and consumer spending typically
show positive trends during this phase.
 Recession: Following the peak, the economy enters a phase of
contraction or recession. This phase is characterized by a decline in
economic activity, with falling production, employment, and income
levels. Consumer and business confidence decreases, leading to
reduced spending and investment. Economic indicators such as GDP
growth rate, industrial production, and consumer spending show
negative trends during this phase.
 Depression: The trough represents the lowest point of the
business cycle, where economic activity reaches its lowest level.
Unemployment tends to be high, and businesses may operate well
below capacity. Consumer and business confidence are typically
low, leading to minimal spending and investment. While
depressions are severe and prolonged downturns, they are less
common than recessions.
 Recovery: After reaching the trough, the economy begins to
recover, marking the start of a new expansion phase. This phase is

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 characterized by increasing economic activity, rising production,
employment, and income levels. Consumer and business confidence
gradually improve, leading to higher spending and investment.
Economic indicators start showing positive trends again, signaling
the end of the recession and the beginning of a new economic
cycle.

Characteristic of Business Cycle

1. It occurs: The business cycle is a natural feature of market economies,
representing the periodic fluctuations in economic activity over time. These
fluctuations are driven by various factors such as changes in consumer and
business confidence, shifts in government policies, technological advancements,
and external shocks like natural disasters or geopolitical events.

2. It is all embracing: The business cycle affects all sectors of the economy,
including production, employment, income, spending, and investment. It
impacts both goods and services industries, as well as financial markets. No
sector is immune to the effects of the business cycle, although some sectors
may be more sensitive or responsive than others.

3. It is wave length: The business cycle is characterized by repetitive patterns

of expansion, peak, contraction, and trough. These cycles typically exhibit
varying lengths and amplitudes, meaning that the duration and severity of each
phase can differ from one cycle to another. However, they generally follow a
similar pattern of boom and bust over time.

4. The process is cumulative and self reinforcing: Economic fluctuations

during the business cycle are often cumulative and self-reinforcing. For example,
during an expansion phase, rising consumer spending may lead to increased
business investment, which in turn stimulates further economic growth.
Conversely, during a contraction phase, declining consumer confidence may lead
to reduced spending, causing businesses to cut back on production and
investment, further exacerbating the downturn.

5. The cycles will be similar but not identical: While the business cycle
exhibits recurring patterns, each cycle is unique and influenced by a variety of
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factors specific to its time period. Economic conditions, policy responses,
technological advancements, and external shocks all contribute to shaping the
characteristics and outcomes of each cycle. Therefore, while there may be
similarities between cycles, no two cycles are identical.

Inflation
Inflation occurs when the prices of goods and services in an economy rise over
time. This means that the purchasing power of a unit of currency decreases,
leading to a decrease in the value of money. Inflation can be caused by various
factors, including increased demand for goods and services, supply chain
disruptions, expansionary monetary policies (such as increasing the money
supply), or rising production costs.

Effects of Inflation:
1. Reduction in purchasing power: As prices rise, consumers can buy fewer
goods and services with the same amount of money, leading to a decrease in
real income and a lower standard of living.

2. Uncertainty: Inflation can create uncertainty about future price levels,

making it difficult for businesses to plan investments and for individuals to make
financial decisions.

3. Redistribution of income: Inflation can lead to a redistribution of income

and wealth, with borrowers benefiting from the decrease in the real value of
their debts and creditors experiencing a decrease in the real value of their
assets.

4. Interest rates: Central banks may respond to inflationary pressures by

increasing interest rates to curb spending and cool down the economy

Types of Inflation
A. On the Basis of Causes:
(i) Currency inflation: This type of inflation is caused by the printing of
currency notes.
(ii) Credit inflation: Being profit-making institutions, commercial banks
sanction more loans and advances to the public than what the economy needs.
Such credit expansion leads to a rise in price level.
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(iii) Deficit-induced inflation: The budget of the government reflects a deficit
when expenditure exceeds revenue. To meet this gap, the government may ask
the central bank to print additional money. Since pumping of additional money is
required to meet the budget deficit, any price rise may the be called the deficit-
induced inflation.

(iv) Demand-pull inflation: An increase in aggregate demand over the

available output leads to a rise in the price level. Such inflation is called
demand-pull inflation (henceforth DPI). But why does aggregate demand rise?
Classical economists attribute this rise in aggregate demand to money supply.

(v) Cost-push inflation: Inflation in an economy may arise from the overall
increase in the cost of production. This type of inflation is known as cost-push
inflation (henceforth CPI). Cost of production may rise due to an increase in the
prices of raw materials, wages, etc. Often trade unions are blamed for wage rise
since wage rate is not completely market-determinded.

B. On the Basis of Speed or Intensity:

(i) Creeping or Mild Inflation: If the speed of upward thrust in prices is slow
but small then we have creeping inflation. What speed of annual price rise is a
creeping one has not been stated by the economists. To some, a creeping or
mild inflation is one when annual price rise varies between 2 p.c. and 3 p.c. If a
rate of price rise is kept at this level, it is considered to be helpful for economic
development. Others argue that if annual price rise goes slightly beyond 3 p.c.
mark, still then it is considered to be of no danger.

(ii) Walking Inflation: If the rate of annual price increase lies between 3 p.c.
and 4 p.c., then we have a situation of walking inflation. When mild inflation is
allowed to fan out, walking inflation appears. These two types of inflation may
be described as ‗moderate inflation‘. Often, one-digit inflation rate is called
‗moderate inflation‘ which is not only predictable, but also keep people‘s faith on
the monetary system of the country. Peoples‘ confidence get lost once
moderately maintained rate of inflation goes out of control and the economy is
then caught with the galloping inflation.

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(iii) Galloping and Hyperinflation: Walking inflation may be converted into
running inflation. Running inflation is dangerous. If it is not controlled, it may
ultimately be converted to galloping or hyperinflation. It is an extreme form of
inflation when an economy gets shattered.‖ Inflation in the double or triple digit
range of 20, 100 or 200 p.c. a year is labelled ―galloping inflation‖.

Deflation
Deflation occurs when the general price level of goods and services in an
economy decreases over time. This means that the purchasing power of a unit of
currency increases, leading to an increase in the value of money. Deflation can
be caused by factors such as decreased demand for goods and services,
technological advancements leading to lower production costs, or restrictive
monetary policies.

Problems of Deflation
1. Effects of production : Deflation can lead to decreased production as
businesses experience reduced demand for their goods and services. When
prices are falling, consumers may delay purchases in anticipation of further price
declines, leading to reduced revenue for businesses. This can result in reduced
investment in production capacity, layoffs, and even business closures.

2. Effect on employment: Reduced production and demand can lead to higher

unemployment rates. As businesses cut costs in response to declining revenue,
they may lay off workers or reduce working hours to cope with decreased
demand for their products or services. This can exacerbate economic downturns
and prolong periods of high unemployment.

3. Effect on income distribution: Deflation can exacerbate income inequality.

Those with fixed incomes, such as pensioners or individuals on fixed salaries,
may see their purchasing power increase during deflationary periods. However,
individuals reliant on wages or income from investments may experience a
decline in real income as prices fall, leading to a decrease in their standard of
living.

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4. Effects on debtors and creditors: Deflation can have significant effects on
borrowers and lenders. Debtors may face increased real debt burdens as the
value of their debts remains constant or even increases in real terms while
prices and incomes decline. This can lead to defaults on loans, bankruptcies, and
a contraction in credit availability. On the other hand, creditors may benefit from
deflation as the real value of the money they are owed increases.

5. Political and social consequence: Deflationary periods can lead to social

and political instability. High unemployment, declining incomes, and increased
economic hardship can contribute to social unrest, political polarization, and
challenges to established political systems. Governments may face pressure to
implement policies to stimulate economic growth, but such measures can be
politically contentious and may not always be effective in reversing deflationary
trends.

Effects of Deflation

1. Decreased consumption: Consumers may delay purchases in anticipation

of further price declines, leading to reduced demand for goods and services and
a decrease in economic activity.

2. Increased real debt burdens: Debtors may face increased real debt
burdens as the value of their debts remains constant or even increases in real
terms while prices decline

3. Rising unemployment: Deflation can lead to higher unemployment rates as

businesses cut costs in response to decreased demand and lower revenue.

4. Hoarding of cash: Individuals and businesses may hoard cash during

deflationary periods, further reducing economic activity and exacerbating
deflationary pressures.

Monetary Policy

This involves actions taken by a country's central bank to control the money
supply and interest rates to achieve macroeconomic objectives such as

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controlling inflation, stabilizing currency exchange rates, and promoting
economic growth

Tools of Monetary Policy

1. Interest rates: Central banks can adjust interest rates to influence

borrowing and spending in the economy. Lowering interest rates encourages
borrowing and spending, which stimulates economic activity, while raising
interest rates can help to cool down an overheating economy and control
inflation

2. Open market operations: Central banks buy and sell government securities
in the open market to influence the money supply and interest rates. Purchasing
securities injects money into the economy, while selling securities withdraws
money from the economy.

3. Reserve requirements: Central banks can set the amount of reserves that
banks are required to hold, which affects the amount of money that banks can
lend. Lowering reserve requirements increases the amount of money banks can
lend, stimulating economic activity, while raising reserve requirements reduces
lending and can help control inflation.

4. Forward guidance: Central banks may provide guidance or signals about

future monetary policy decisions to influence market expectations and behavior.

Fiscal Policy

This refers to the use of government spending and taxation to influence the
economy. Fiscal policy aims to achieve macroeconomic objectives such as
economic growth, employment, and price stability.

Tools of Fiscal Policy

1. Government spending: Increasing government spending on infrastructure,

education, healthcare, or other programs can stimulate economic activity and
create jobs.

2. Taxation: Adjusting tax rates can affect household disposable income and
business profits, influencing consumption and investment behavior. Cutting

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taxes can stimulate spending and investment, while raising taxes can help to
reduce inflationary pressures or finance government spending.

3. Government borrowing: Governments can finance budget deficits by

borrowing from domestic or foreign investors. However, excessive government
borrowing can lead to higher interest rates and crowding out private investment.

4. Automatic stabilizers: Certain government programs, such as

unemployment benefits and progressive income taxes, automatically adjust in
response to economic conditions, providing a stabilizing influence during
economic downturns.

Balance of Payment

The balance of payments (BoP) is a vital economic indicator that provides

insights into a country's economic health and its transactions with the rest of the
world.

Components of BOP

1. Current Account: This records a nation's transactions in goods, services,

primary income (such as wages and investment income), and secondary income
(such as aid and remittances). A surplus in the current account indicates that a
country is exporting more than it imports, while a deficit indicates the opposite.

2. Capital Account: This measures transfers of capital and assets between a

country and the rest of the world, including non-financial assets like patents and
trademarks. It also includes debt forgiveness and migrant transfers.

3. Financial Account: This tracks changes in ownership of foreign assets and

liabilities, including foreign direct investment (FDI), portfolio investment, and
changes in reserve assets held by central banks.

Ways of Balance of Payment influence Business Decisions

1. Exchange Rate Management: Fluctuations in a country's balance of

payments can affect its exchange rate. A strong current account surplus, for
instance, might lead to currency appreciation, making imports cheaper and

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exports more expensive for businesses. Conversely, a deficit might lead to
currency depreciation, boosting export competitiveness but potentially increasing
input costs for businesses reliant on imports

2. Market Opportunities and Risks: A country with a current account surplus

may present attractive market opportunities for businesses looking to export
goods and services. Conversely, a country with a deficit may indicate higher
risks due to potential currency devaluation or economic instability.

3. Access to Capital: The capital and financial accounts reflect a country's

ability to attract foreign investment. A favorable balance of payments can
indicate a stable investment environment, providing businesses with access to
capital for expansion or investment projects.

4. Policy Implications: Government policies aimed at addressing imbalances

in the balance of payments, such as tariffs, subsidies, or exchange rate
interventions, can directly impact business operations and strategies. For
example, trade restrictions imposed to reduce imports may affect supply chains
and sourcing decisions for businesses.

5. Market Sentiment and Investor Confidence: A country's balance of

payments can influence investor sentiment and confidence in the economy.
Businesses operating in such environments need to consider market perceptions
and potential changes in investor behavior.

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